Is 1st half gain 2nd half pain?

Since climbing back from the depths of recession, Canada’s sound economic footing relative to the United States has been a source of national pride and self-congratulation.

But as much as ever, the U.S. economy’s weaknesses become Canada’s own, an inescapable reality that could be made painfully clear in the second half of 2011.

The disappointing start to the year in the United States now threatens to spread north, raising the prospect of an imminent slowdown in Canadian economic growth. Many observers, the Bank of Canada among them, are advising Canadians to lower their expectations.

“We could lapse into this lowgrowth environment, with low productivity and a high Canadian dollar,” said Brian Bethune, chief financial economist for North America at IHS Global Insight. “I’m not sure that’s a very exciting future.” To him, a drop-off in growth is “baked in the cake.”

Last year, the global economic recovery suffered a setback, one significant enough to stoke fears of a return to recession and incite the U.S. Federal Reserve to again intervene by injecting billions of dollars of liquidity.

Whether a similar regression stains 2011 depends on two key questions: Will the Canadian dollar remain high? And will the U.S. recovery, which has so far been a start-stop affair, become sturdy enough to drive demand for Canadian exports?

The answer to the first question is fairly clear, Bank of Canada governor Mark Carney said this week.

The loonie’s “persistent strength” will remain the bane of the Canadian exporter, he said, one of the headwinds that will result in more modest economic growth over the next several quarters.

There is no consensus, however, on the immediate future of the U.S. economy, mainly because the current cyclical recovery in the United States is so historically atypical, said Nigel Gault, chief U.S. economist at IHS.

Unlike almost any other that came before, this recovery is forced to endure without a comeback -or even stability -in the housing sector. “It’s extremely unusual,” Mr. Gault said. “In a traditional robust expansion, housing would have been one of the leading sectors.”

But U.S. housing continues to hit new lows, with possible years ahead before home prices begin to rise substantially.

“That means the economy just can’t come back as quickly as it would in a normal recovery,” Mr. Gault said.

Millions of houses remain vacant, prices continue to fall, and the limited sales activity occurring is dominated by distressed properties.

With new-home construction almost at an “irreducible minimum,” the housing sector could not prove more of a drag on U.S. GDP, Mr. Bethune said. “You’ve got this anchor being dragged along.”

Growth in the first quarter in the United States is likely to come in at about 1.8% on an annualized basis, answering the question of whether a U.S. slowdown should be expected, Mr. Gault said. “We’ve had a pause already. We’re in the middle of it.”

These interruptions in the economic cycle set the current recovery apart in a second sense.

“In most recoveries, once they get going, they really get going,” Mr. Gault explained. “In theory, GDP bottomed out in 2009, and we’ve been growing since then. So we’re almost two years in. Normally at this point, you’d be comfortably above the previous GDP peak.”

That mark, however, was only just reached in the United States in the last quarter of 2010.

But perhaps conventional wisdom does not strictly apply, suggested Michael Gregory, senior economist at BMO Capital Markets. And perhaps decent growth is not predicated on stability in housing, he said.

Mr. Gregory likens the U.S. economy to a Bundt cake. “There’s a hole in the middle, but the cake is still rising.”

As a share of the overall U.S. economy, housing has shrunk to a record low, one factor limiting the havoc real estate volatility can wreak on markets, Mr. Gregory said.

In addition, just as rock-bottom interest rates failed to reignite housing activity, so too will rate hikes avoid further traumatizing the depressed residential sector, he said.

The U.S. recovery will continue despite its perpetual anchor, he said. “To me there’s a pretty sizeable adjustment to come, but that doesn’t bother the economy as much as it did a few years ago.”

Canada, as a result, will escape a second-half pause, Mr. Gregory predicted, “simply because the U.S. is starting to have that self-sustaining momentum.”

If housing is the U.S. economy’s anchor, then manufacturing is its buoy.

In the first quarter of this year, factory production in the United States grew by 9.1% on an annualized basis, a huge bump driven by emerging-market demand in Asia and Latin America.

“The U.S. export machine is humming,” Mr. Gregory said. “They realize where their bread’s buttered. Unfortunately, our bread’s buttered the same way.”

Whereas U.S. manufacturers have the benefit of a depressed greenback, making their prices more competitive on global markets, Canadian exporters have to contend with the challenges of an elevated loonie.

Under the assumption that the dollar continues to trade around US$1.03, the Bank of Canada cut growth estimates in six of the seven upcoming quarters.

Mr. Carney said Canada’s solid first quarter was an anomaly and will give way to 2% annualized growth in the current quarter.

“What we are seeing on the trade side is still quite a challenging situation for our exporters -and it could be more difficult,” he said.

In keeping to its plan for gradual increases in its key lending rate, however, Mr. Carney faces a dilemma.

The interest-rate differential with the United States already attracts higher capital flows, which in turn put upward pressure on the loonie. Further rate hikes, while the U.S. Federal Reserve is expected to hold steady until 2012, will only exacerbate the problem.

“That process becomes self-fulfilling,” Mr. Bethune said. “The capital inflows push the Canadian dollar up higher, which then rationalizes more capital inflows. You get this cycle, which can continue for some period of time.”

Many are anticipating the central bank to raise rates midJuly, at a time when second-quarter results will become apparent. But those results could prove disappointing, Mr. Bethune said. “It could well keep the Bank of Canada on hold through the end of 2011,” he said.

With the absence of substantial inflationary pressures, the central bank at least has the luxury of flexibility in timing its rate increases.

A good thing, since raising rates too soon would simply add another encumbrance to Canadian growth, Mr. Gregory said.

“We have to make sure the U.S. recovery and U.S. economic expansion is self-supporting, it is continuing, it is solid and it is entrenched.”

That might require the U.S. domestic economy to join the burgeoning export sector on the recovery track, Mr. Bethune said. But the U.S. customer has to budget for rising oil and gasoline prices as a result of volatility and war in North Africa and the Middle East.

That means less spending on domestic goods and services. “Any time you have a run-up in oil and gasoline prices like we’ve seen, that has a pretty retarding effect on growth in the U.S., as I’m sure we’ll have in Canada as well,” Mr. Bethune said.

While global oil supply is generally not limited, prices reflect geopolitical risks in a risk premium, he explained. “You’re just going to see a messy repricing of that risk premium every day. We’re dependent on a highly unstable part of the world.”

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